Opening up

Ellen McGrattan explores the relationship between economic growth and openness to foreign investors

Economic theory predicts that a country will experience increased economic growth by opening its markets to foreign direct investment (FDI). Foreign investors could provide capital that is often sorely lacking. Of particular need: “technology capital”—things like research and development, proprietary brands, patents and organizational capital—ideas or methods that firms develop internally and then use in as many locations as they choose, both at home and abroad.

Combined with local labor and the right legal and regulatory institutions, capital from abroad can spur growth in advanced as well as emerging markets. Yet, with few exceptions, empirical research has not been able to substantiate that prediction, a situation that has perplexed economists for decades.

In a recent staff report, Minneapolis Fed monetary adviser Ellen McGrattan, also at the University of Minnesota, offers an explanation. “I show that these inconclusive findings do not contradict theory, but in fact are to be expected when countries are in transition to capital market openness.”

In “Transition to FDI Openness: Reconciling Theory and Evidence” (Staff Report 454), McGrattan suggests that the inability of prior studies to find a robust positive relationship between FDI openness and growth doesn’t necessarily mean that such effects don’t exist. Rather, she demonstrates, the benefits may appear to be insignificant or even negative only during the transition period itself. After open markets mature and the policies that support them evolve, the benefits become large and obvious. Notably, this effect is most pronounced for smaller countries.

To explore the relationship between FDI openness and growth, McGrattan’s paper moves through three stages. The first step is to look at what happens in a hypothetical world with just two countries, a small country (in terms of population and technology level) that unilaterally opens up to FDI from its large neighbor. She finds that initially, per capita GDP and employment drop below historical trends. This reverses only after restrictions reach a critical point of relaxation.

The second step is to build a more realistic multicountry model with policies that generate capital flows like those observed in data from 104 countries between 1980 and 2005. In this model, matched to actual data with realistic FDI flows, McGrattan finds that there is no systematic relationship between economic performance and FDI levels. In other words, she replicates the results of most other empirical research on the question.

The final step is, in a sense, a blend of the first two. For each country in her sample of 104, she estimates the growth impact and welfare gains of unilateral relaxation of capital market restrictions. With the model developed for step two, with its realistic parameters, she thus performs a country-by-country experiment. What will happen to growth and welfare in each if it eases its constraints on FDI and borrowing/lending?

The model’s predictions for GDP growth when countries are close to completely open are revealing. McGrattan finds an inverse relationship between a host country’s relative size and its growth following capital market liberalization—larger countries experience smaller growth benefits. But in almost all cases, the boost in growth following FDI liberalization is substantial, with the highest estimates around 7 percentage points annually. “[T]he benefits in terms of higher GDP growth and welfare … can be huge,” writes McGrattan, “especially for small countries.”

There are two reasons that GDP and employment measures initially decline after FDI openness is implemented, according to McGrattan. First, when relaxation of restrictions is expected, households increase consumption and leisure in anticipation of higher permanent income, which in turn reduces domestic investment and labor.

The second factor behind apparent GDP declines is actually a measurement issue. Part of the increased FDI will typically be booked as “expensed intangible investment” by the corporation and therefore not counted as part of corporate profits. As such, it will not be captured in measured GDP. As McGrattan points out, theory predicts that intangible investments are abnormally high while barriers to FDI are being removed, resulting in a negative correlation between FDI investment and host country GDP during the transition period.

By taking account of a transition period, McGrattan reconciles economic theory predicting that openness to FDI will lead to higher growth and welfare for host countries with the lack of robust empirical evidence for such benefits. In McGrattan’s model, benefits to FDI openness are large, but only once a certain threshold of openness is attained.

Nonetheless, McGrattan’s findings leave economists with two challenges. The first involves defining the characteristics of the openness threshold. A better-defined threshold could allow for more accurate economic modeling, predictions and policy corrections. The second, and more significant, challenge, according to McGrattan, is to abandon the standard method for analyzing the effects of FDI openness. Her model is a critical first step.